Advanced Placement Macroeconomics: Opportunity Cost and Comparative Advantage Study Guide

Understanding Opportunity Cost and Increasing Costs

• Economics is often incorrectly dismissed as being merely cost/benefit analysis. While this concept is vital, one of the most complex concepts to master is the opportunity cost associated with specific choices.

• Economic entities, including entire countries, frequently face increasing opportunity costs as they strive to increase production of specific items.

• A classic scenario involves a country at war that needs to increase its production of armaments:

  • Initially, increasing military production has a relatively low opportunity cost because the first factories converted to military use are generally well-suited for such production.
  • As the demand for armaments persists, factories that are poorly suited for weapon production must be converted. This results in a very high opportunity cost: little is added to the total output of armaments, while a significant amount of consumer goods is sacrificed.

• This concept of increasing opportunity costs is visually manifested in a production possibilities curve (PPC) that is concave towards the origin.

Analysis of Production Possibilities Curve (Figure 2.1)

• In Figure 2.1, the production of military goods is measured against civilian goods (both in billions of dollars).

• When the government increases military output from $20$ billion to $30$ billion, the opportunity cost in terms of civilian goods forgone is small: $660$ billion minus $650$ billion, resulting in an opportunity cost of $10$ billion.

• When the country is already producing a high volume of military goods and attempts to increase production further, the cost rises sharply. For example, moving from $70$ billion to $80$ billion in military goods results in an opportunity cost of $200$ billion ($600$ billion minus $400$ billion).

Specialization and Trade

• Opportunity cost is the underlying explanation for the vast amount of trade between individuals, firms, and nations.

• In modern economies, few entities produce all their own goods and services. Instead, individuals earn money at jobs to buy goods made by others. Examples include:

  • Computer manufacturers rarely produce all their own parts; they purchase components from various suppliers.
  • Countries specialize in specific goods. For instance, no firms in the United States currently manufacture television sets, and very few produce consumer electronics. Instead, U.S. businesses concentrate on other goods and services, importing televisions from abroad.

• Trade benefits both parties even if one country is more efficient at producing every single good than another country. Benefits are realized as long as each entity specializes in the task for which they possess a lower opportunity cost. This principle is known as comparative advantage.

Absolute Advantage versus Comparative Advantage

• Absolute Advantage: This occurs when a person or entity can perform an activity using fewer resources (such as time) than another.

• Comparative Advantage: This occurs when a person or entity can perform a task at a lower opportunity cost than another person or entity.

• Historical Context:

  • Adam Smith, the founder of modern economics, initially believed that if one party had an absolute advantage in all activities, they should work alone.
  • David Ricardo, in the early $1800$s, realized that specialization and trade benefit everyone even if one party holds an absolute advantage in every activity.

Example 1: Ty and Jessica (Lawn-Care Services)

• Ty and Jessica provide two services: mowing and trimming (sweeping, edging, and cleanup). The time required for each task (in minutes) is as follows:

  • Ty: Mow = $60$ minutes; Trim = $40$ minutes.
  • Jessica: Mow = $75$ minutes; Trim = $90$ minutes.

• Ty has the absolute advantage in both activities because he completes them in less time.

• Identifying Comparative Advantage via Opportunity Cost:

  • Opportunity Cost of Mowing One Lawn:
    • For Ty: In the $60$ minutes it takes to mow, he could have trimmed $3/2$ (or $1.5$) lawns ($60/40$).
    • For Jessica: In the $75$ minutes it takes to mow, she could have trimmed only $5/6$ (or $75/90$) of a lawn.
    • Result: Jessica has the comparative advantage in mowing because $5/6 < 3/2$.
  • Opportunity Cost of Trimming One Lawn:
    • For Ty: In the $40$ minutes it takes to trim, he could have mowed $2/3$ of a lawn ($40/60$).
    • For Jessica: In the $90$ minutes it takes to trim, she could have mowed $6/5$ (or $1.2$) lawns ($90/75$).
    • Result: Ty has the comparative advantage in trimming because $2/3 < 6/5$.

• Rules of Opportunity Cost:

  1. The opportunity cost of one activity is the reciprocal of the opportunity cost of the other activity for that same person (e.g., Ty's costs are $3/2$ and $2/3$).
  2. Unless a person is equally capable at both activities, each person will have a comparative advantage in exactly one activity.

• Productivity Gains from Specialization:

  • Before specializing: Jessica takes $165$ minutes ($90 + 75$) and Ty takes $100$ minutes ($60 + 40$) for a total of $265$ minutes to do two lawns.
  • After specializing: Jessica mows two lawns ($75 \times 2 = 150$ minutes) and Ty trims two lawns ($40 \times 2 = 80$ minutes) for a total of $230$ minutes.
  • Efficiency improvement: They save $35$ minutes, which is a $13\%$ reduction in the total time required.

Example 2: Mark and Doreen (Car Stereo Installation)

• Productivity is measured in output per hour:

  • Mark: $6$ Radios or $2$ Speakers per hour.
  • Doreen: $10$ Radios or $5$ Speakers per hour.

• Opportunity Cost Breakdown:

  • Installing 1 Radio:
    • Mark: $1/3$ speaker ($2/6$).
    • Doreen: $1/2$ speaker ($5/10$).
  • Installing 1 Speaker:
    • Mark: $3$ radios ($6/2$).
    • Doreen: $2$ radios ($10/5$).

• Specialization:

  • Mark has the comparative advantage in installing radios ($1/3 < 1/2$).
  • Doreen has the comparative advantage in installing speakers ($2 < 3$).

Questions & Discussion

• Question 1: What is the difference between comparative advantage and absolute advantage?

  • Absolute advantage refers to the ability to produce more of a good or service using the same amount of resources, or the same amount using fewer resources. Comparative advantage refers to the ability to produce a good or service at a lower opportunity cost than others.

• Question 2: Case study of a newlywed couple (Mike and Debbie) time spent on chores (in minutes):

  • Mike: Vacuum a room = $60$; Wash a load of dishes = $30$.
  • Debbie: Vacuum a room = $45$; Wash a load of dishes = $45$.
  • (A) Mike's opportunity cost of vacuuming: $2$ loads of dishes ($60/30$).
  • (B) Mike's opportunity cost of washing dishes: $1/2$ of a vacuumed room ($30/60$).
  • (C) Debbie's opportunity cost of vacuuming: $1$ load of dishes ($45/45$).
  • (D) Debbie's opportunity cost of washing dishes: $1$ vacuumed room ($45/45$).
  • (E) Absolute advantage in vacuuming: Debbie ($45 < 60$).
  • (F) Absolute advantage in washing dishes: Mike ($30 < 45$).
  • (G) Comparative advantage in vacuuming: Debbie ($1 < 2$).
  • (H) Comparative advantage in washing dishes: Mike ($1/2 < 1$).
  • (I) Assignment: Mike should wash dishes and Debbie should vacuum because they each hold a comparative advantage in those respective tasks.

• Question 3: Case study of Andy and Hannah (Cleaning time in minutes):

  • Andy: Cleaning offices = $60$; Cleaning jail cells = $30$.
  • Hannah: Cleaning offices = $20$; Cleaning jail cells = $15$.
  • (A) Andy's opportunity cost of cleaning offices: $2$ jail cells ($60/30$).
  • (B) Hannah's opportunity cost of cleaning offices: $4/3$ or $1.33$ jail cells ($20/15$).
  • (C) Andy's opportunity cost of cleaning jail cells: $1/2$ office ($30/60$).
  • (D) Hannah's opportunity cost of cleaning jail cells: $3/4$ or $0.75$ office ($15/20$).
  • (E) Absolute advantage in cleaning offices: Hannah ($20 < 60$).
  • (F) Absolute advantage in cleaning jail cells: Hannah ($15 < 30$).
  • (G) Comparative advantage in cleaning offices: Hannah ($4/3 < 2$).
  • (H) Comparative advantage in cleaning jail cells: Andy ($1/2 < 3/4$).
  • (I) Assignment: Andy should clean jail cells and Hannah should clean offices based on comparative advantage.

• Question 4: International Trade (United States and Japan) output per hour:

  • United States: $12$ Cars; $4$ Computers.
  • Japan: $10$ Cars; $6$ Computers.
  • (A) U.S. opportunity cost of making cars: $1/3$ computer ($4/12$).
  • (B) Japan's opportunity cost of making cars: $3/5$ or $0.6$ computer ($6/10$).
  • (C) U.S. opportunity cost of making computers: $3$ cars ($12/4$).
  • (D) Japan's opportunity cost of making computers: $5/3$ or $1.67$ cars ($10/6$).
  • (E) Absolute advantage in cars: United States ($12 > 10$).
  • (F) Absolute advantage in computers: Japan ($6 > 4$).
  • (G) Comparative advantage in cars: United States ($1/3 < 3/5$).
  • (H) Comparative advantage in computers: Japan ($5/3 < 3$).
  • (I) Assignment: The U.S. should produce cars and Japan should produce computers because those are their respective areas of comparative advantage.

• Question 5: Use the law of comparative advantage to explain why self-sufficiency leads to a lower standard of living.

  • Self-sufficiency requires an entity to produce goods even when they have a high opportunity cost for doing so. By specializing according to comparative advantage and trading, entities can consume a combination of goods that lies outside their individual production possibilities curve, thereby increasing the total quantity of goods available and raising the standard of living.